Europe's central bank must show some backbone

The bank needs to remember the legacy of its former head, who knew it was essential to resist political pressure

By Melvyn Krauss

The most surprising and controversial thing about last month's rate hike by the European Central Bank (ECB) was that, after two and a half years of keeping interest rates at exceptionally low levels, the bank ventured an increase of only 25 basis points with no promise of more to come. Political pressure on Europe's central bank may be the reason for that timid move.

Jean-Claude Trichet, the current ECB president, may be in the same job but not the same environment as his predecessor Wim Duisenberg, who famously remarked, "I hear the politicians, but I don't listen."

Political pressure on the ECB today is much greater than in Duisenberg's time. The political environment is much more hostile. Some of this pressure may be seeping through and affecting ECB policy decisions.

This is an extremely negative development -- and one of the central bank's biggest challenges for this year. Not only will politicians' influence be toward monetary excess, which of course is a serious enough matter for a bank whose primary mandate is price stability, but also the excess will constitute a serious barrier to structural reform, which is essential for European prosperity in a competitive global economy.

Increasingly, Europe's politicians regard excess liquidity and economic reform as substitutes for one another. The more the bank gives on liquidity, the less the politicians will do on reform. Duisenberg recognized this linkage and held firm. The ECB's paltry rate hike last month, together with the supine promise of no plans for further monetary tightening, demonstrates that Trichet is no Duisenberg.

Europe's finance ministers have played a clever game with the ECB. Even though they were already resigned to a 25-basis-point rate increase, the politicians made a big show of being opposed to it, aiming to prevent what they really feared and what was certainly more warranted: a 50-basis-point hike and a warning of more on the way.

Their strategy worked. Luxembourg's finance minister, Jean-Claude Juncker, diplomatically declared after last month's meeting that, "The result could have been worse."

Indeed, even the markets were fooled, giving the ECB a good grade for its unremarkable rate hike.

Inflationary expectations, as measured by the rates on certain market instruments, actually fell after the hike, indicating increased confidence that the ECB will keep a lid on price pressures.

Although the meager rate hike was presented as a consensus of the ECB's Governing Council, it soon became apparent that the decision had been controversial. Some council members, unhappy with Trichet's dovish stance at last month's press conference, made their displeasure known via the press soon after.

In an interview with Frankfurter Allgemeine Zeitung, for example, Bundesbank president Axel Weber made it clear that future rate hikes were very much on the table. Others spoke out as well, and the futures markets quickly predicted another 25-basis-point rate hike in March. The consensus alleged at the press conference simply did not exist.

With political pressures encroaching on the bank's policy decisions and a faux consensus, it is not surprising that there is now nostalgia in Frankfurt for earlier times and for Wim Duisenberg, even among his former critics. Duisenberg's great skills -- under-appreciated by the press and public alike -- were genuine consensus-building in a potentially divisive body and, in Trichet's own words, "an exceptional ability to keep his nerve in some highly demanding and extremely hostile environments."